Question

What is the profit maximizing principle? Why is it used to determine the optimal quantity of a product or service to produce? What are the important costs for decision makers to consider? For example, should sunk costs be considered or opportunity costs or both? Consider a recent decision you made. Did you consider opportunity costs? Sunk costs? Both?

Answer 1

Profit maximization is the short run or long run process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem. The total revenue–total cost perspective relies on the fact that profit equals revenue minus cost and focuses on maximizing this difference, and the marginal revenue–marginal cost perspective is based on the fact that total profit reaches its maximum point where marginal revenue equals marginal cost.

The general rule is that firm maximizes profit by producing that quantity of output where marginal revenue equals marginal costs. The profit maximization issue can also be approached from the input side. That is to maximize profit the firm should increase usage of the input "up to the point where the input's marginal revenue product equals its marginal costs". So mathematically the profit maximizing rule is MRP_L = MC_L. This is why, profit maximizing is used to determine the optimal quantity of a product or service to produce.

The following costs are important for decision making:

Relevant cost:

Relevant costing assigns future costs and revenues to the decision being made. It includes only those cash flows which will be affected by the decision.

There is commonly an overlap between the two methods, as variable costs will commonly be future costs affected by the decision, and hence also be considered relevant.

The remainder of this article will focus on the use of relevant costing for short-term or one-off decisions.

Relevant costs must be future (incremental) cash flows affected by the decision and therefore ignore the following:

• Sunk costs – those which have already been incurred before the decision is made, for example if a company has already purchased material then the cost of the material at that time is irrelevant. Instead, the current replacement value (if material is still regularly used) or the scrap value (if material is no longer used) would be considered the relevant cost to the decision.
• Unavoidable (committed) costs – those costs which will be incurred/cannot be avoided regardless of the decision. The difference between these and sunk costs is the time at which the costs are incurred. These are future costs, whereas sunk costs are in the past.
• Apportioned costs – those costs which have been split between units of production or service based on some arbitrary allocation method, for example fixed machine service costs apportioned based on the number of machine hours used.

Fixed, variable, and mixed costs: A fixed cost, such as rent, does not change in lock step with the level of activity. Conversely, a variable cost, such as direct materials, will change as the level of activity changes. Those few costs that change somewhat with activity are considered mixed costs. It is important to understand the distinction, since a decision to alter an activity may or may not alter costs. For example, shuttering a facility may not terminate the associated building lease payments, which are fixed for the duration of the lease.

Product costs: A product may be an incidental by-product of a production process (such as sawdust at a lumber mill). If so, it does not really have any cost, since its cost would have been incurred anyways as a result of the production of the main product. Thus, selling a by-product at any price is profitable; no price is too low.

Allocated costs: Overhead costs are allocated to manufactured goods only because it is required by the accounting standards (for the production of financial statements). There is no cause-and-effect between the creation of one additional unit of production and the incurrence of additional overhead. Thus, there is no reason to include allocated overhead in the decision to set a price for one additional unit.

Discretionary costs: Only a few costs can actually be dropped without causing any short-term harm to an organization. Examples are employee training and maintenance. Over the long-term, delaying these expenditures will eventually have a negative effect. Thus, managers need to understand the impact of their decisions over a period of time when determining which costs to cut back.

Step costs: Though some costs are essentially fixed, it may be necessary to make a large investment in them when the activity level increases past a certain point. Adding a production shift is an example of a step cost. Management should understand the activity volumes at which step costs can be incurred, so that it can manage around them - perhaps delaying sales or outsourcing work, rather than incurring step costs.

Sunk costs do include opportunity costs; the costs of the benefit foregone when the decision being made means that an alternative opportunity must be rejected. For example, if a company owns an asset which can be leased out to other companies, but is used on a short-term internal contract instead, then the relevant cost would include the external rental income foregone.